Wednesday, June 30, 2010

Rollin with My Puts

I received another question, this time from tjktrader, regarding how to manage long put positions when/if the market moves adversely. As is typically the case there isn't always one right way, but let's review a few adjustment ideas worth considering when playing with puts. The adjustments fall into two camps- ones you may use when the underlying moves adversely from the get-go causing the put to lose money and ones you may use once you've accumulated a decent chunk of profits on the put. The latter camp will be in focus today.

Suppose we purchased a SPY August 110 put option for $4.50 on June 23rd when the SPY was trading around $109. Given the precipitous fall in the market coupled with the sharp volatility surge over the last week, the put option has risen in value to $7.30 giving us a $280 unrealized gain. Not too shabby! Consider the risk graph displayed below. In this situation, how might a trader adjust the put to protect or hedge him/herself in case the SPY catches a bid and rallies back strong?
[Source: MachTrader]

First, adhere to the K.I.S.S. method and just sell the put to exit the trade. If you're of the opinion the market may bounce back strong and fear coughing up your hard earned gains, then there's nothing wrong with jumping ship with your captured booty.

Second, roll into a vertical put spread by selling a lower strike Aug put. Selling the lower strike put not only helps hedge your delta risk, but also theta and vega risk. Right now there are three ways you could start to give back profits: a rise in SPY, a drop in implied volatility, time decay. Suppose you sell the Aug 105 put for $4.60. Consider your new position in the risk graph below:
The delta risk has dropped from 70 to 20, theta has flipped from hurting your position to helping and your exposure to volatility has been largely eliminated. In addition, you can continue to accumulate profits up until about $510 and are guaranteed to capture at least a $10 profit regardless of how high the SPY may rally.

Yet another adjustments worth consideration is rolling to some type of calendar by selling a July option against the August put. We'll explore one such example tomorrow so stay tuned...